RP iGaming Index: Storm clouds gathering?

Compiled in partnership with Regulus Partners' Paul Leyland, September’s index saw a degree of outperformance after a summer spent broadly tracking the NASDAQ benchmark. Before we get too excited, though, this dead cat bounce comes after several months of share price malaise. Kindred is the stock in focus for this month

There used to be an old stockbroking adage, one suitably based on betting and racing: “Sell in May and go away, come back on St Leger Day”. For our non-UK audience, along with probably a large number of you aged under 45, the St Leger is the last major flat race of the season, held in Doncaster in mid-September.

If the adage were ever true it stopped being so when US brokers came to London and felt that an entire summer of doing very little was rather louche.

The final nail in the coffin was IFRS requirements to get interims out in a manner more timely than late September for companies with a December year-end – which is most of them (March stopped being the calendar year-end in Britain in 1751, though the government and some companies have yet to adjust).

The summer has therefore been full of reporting though little of major note was reported.

This is because the sector’s big news is usually regulatory or M&A-related: earnings watching tends to be defeated by either predictability (less the regulatory drivers) or the sort of volatility that should not change fundamental perceptions of value (high roller wins, sporting results etc).

Gambling company earnings seasons can therefore be rather dull, as this one was – with one or two exceptions (such as this issue’s stock in focus below, Kindred).

All this may change, however, with any investors who did come back after St Leger Day perhaps wishing they hadn’t. We think it may change because there are some early signs of a global slowdown, which could lead to another set of banking problems.

The trouble is, with global debt roughly double what it was in 2007, QE still dribbling on, and interest rates already low to negative, there isn’t a great deal that policy makers can do about any crisis that does hit – not from the conventional liberal-capitalist playbook at any rate.

We are not calling Armageddon – and this is certainly not investment advice – but we are nervous about the wellbeing of the global economy and some key financial institutions.

The gambling sector got through the last financial crisis pretty well on an operational level: pain tended to be a function of corporate leverage rather than top-line performance (although this was worse affected than many obliging management teams expected).

However, it certainly hit growth – proving (perhaps thankfully, given the policy implications of the alternative) that most forms of gambling can be classified as cyclical consumer discretionary.

The reason why 2007-9 was broadly survivable was because most companies could repair their balance sheets, most land-based businesses had double-digit EBITDA margins to buffer themselves and most online companies could count on double-digit secular growth (though some had to be bought by stronger management to unlock this).

Rolling forward to 2020, land-based EBITDA margins are much more under pressure from wider retail issues as well as some gambling specific ones (typically 10% vs. 20%), online secular growth is harder to come by and increasingly expensive (tax, marketing, content etc) and several major companies also have significant levels of leverage.

If the sector does face macro pressure, it is therefore likely to be more severely felt than in 2007-9 – and the pressure itself could be a lot worse.

Those operators thinking that the worst thing that could happen in the medium term is a bad run of results, challenging regulation or being left out of the M&A party could have a nasty surprise in store – and blaming Brexit is unlikely to wash either…

Stock in focus: Kindred
There are no prizes for guessing which two stocks will be in focus this issue – and that at least will allow us to say something positive. One of the biggest online movers of the summer was Kindred, which the market punished aggressively despite reasonable topline performance against tough comps.

Kindred’s Q2 showed the continued pressures being faced in Sweden (as expected, a QoQ improvement but still contribution down £9.2m YoY, or 82% of the EBITDA fall).

Domestically regulated markets excluding Sweden were up 19%, suggesting continued momentum in the UK from 32Red and a strong performance from France (the market that wasn’t supposed to work but has provided very attractive growth for those few operators that got in early and played the regulatory distortions to their advantage).

The increased mix of domestically regulated markets (59%) also led to a material increase in marketing despite World Cup spend in the comps, with 29% revenue on marketing, the highest since 2013. This and higher taxes largely explains the significant reduction in operating margins, with many erstwhile .com operators now experiencing domestically regulated reality in Europe facing similar pressures.

Kindred’s performance captures the issues of early online businesses servicing mature markets in microcosm, in our view.

While the benefits of secular growth are no longer evenly felt (CES Europe was the strongest segment albeit suggesting relative underperformance: +11% but only 8% of the group), product investment, operational efficiencies and .com revenue to reinvest in POC marketing have allowed room to be made for a tougher topline environment, structurally higher costs and increasing competition.

During this long ‘period of adjustment’, events have been sufficiently evenly spaced to be presented as one-off in an otherwise intact growth story. However, with a critical mass of Kindred’s revenue now domestically regulated and more headaches coming (e.g. Norway, Germany and the Netherlands, assuming the latter is likely less problematic for Kindred than some competitors), achieving topline momentum and sustainable margin improvements could be extremely challenging.

Ironically, and perhaps offering long-term hope of sorts, Kindred’s best performing major geography is likely to be the one which the group found the most strategically challenging on domestic licensing.

Disclaimer
The narrative provided represents the opinions of the authors. Any assessment of trends or change is necessarily subjective. The information and opinions provided are not intended to provide legal, accounting, investment or policy advice, nor should they be used as a forecast. Regulus Partners may act, or has acted, for any of the companies and other stakeholders mentioned in this report.